The bailout of Spain’s banks shows the heart of our problem

Summary: The US and Europe have not recovered from the 2008-09 crash in part because we applied first aid, but squandered the time those measures bought for us (at great cost). An essential aspect of post-crash reforms is fixing our financial systems. The bailout of Spain’s banks — expensive for Spain’s people, easy money for the banks — illustrates the problem. Here we give details and alternatives. At the end are links for more information

The modern bankers’ flag

Banks are central institutions in western economies. Almost every severe economic crash has a large bank failure in the early phases. That’s almost inevitable given their exposure to the broad economy, leverage, and reliance on borrowed funds. But their political power makes them resistant to reform, and full recovery from a downturn usually requires their reform. The most important aspect of this is sharing the loses. Banks will use their political strength to shift losses onto other. That’s neither fair, economically sound (as it encourages moral hazard), or necessary.

The US has experienced massive bank failures every decade since 1980, and we’ve yet to learn how to cope with them. This is learned helplessness, a consequence of money usefully applied to shape not only public policy but als0 public outcomes. We saw this demonstrated in the rise and corruption of the Tea Party movement. Born in opposition to bank bailouts, becoming shock troops for election of bank-friendly Republicans (for details see Occupy Wall Street, another futile peasants’ protest).

For a summary of the problem and alternative see “The Heart of the Matter“, John P. Hussman, 11 June 2012 — Excerpt:

In effect, we’re going into another recession because we never effectively addressed the problems that produced the first one, leaving us unusually vulnerable to aftershocks. Our economic malaise is the result of a whole chain of bad decisions that have distorted the financial markets in ways that make recurring crisis inevitable.

… Every major bank is funded partially by depositors, but those deposits typically represent only about 60% of the funding. The rest is debt to the bank’s own bondholders, and equity of its stockholders. When a country like Spain goes in to save a failing bank like Bankia — and does so by buying stock in the bank — the government is putting its citizens in a “first loss” position that protects the bondholders at public expense. This has been called “nationalization” because Spain now owns most of the stock, but the rescue has no element of restructuring at all. All of the bank’s liabilities – even to its own bondholders – are protected at public expense. So in order to defend bank bondholders, Spain is increasing the public debt burden of its own citizens. This approach is madness, because Spain’s citizens will ultimately suffer the consequences by eventual budget austerity or risk of government debt default.

The way to restructure a bank is to take it into receivership, write down the bad assets, wipe out the stockholders and much of the subordinated debt, and then recapitalize the remaining entity by selling it back into the private market. Depositors don’t lose a dime. While the U.S. appropriately restructured General Motors – wiping out stock, renegotiating contracts, and subjecting bondholders to haircuts – the banking system was largely untouched.

The failure of our policy makers to restructure debt resulted in the worst of both worlds – an economy where banks were relieved of the need for transparency (thanks to accounting changes by the FASB), and yet homeowners strapped with bubble-sized mortgage obligations saw very little in terms of debt restructuring. The reason we never got any economic traction in this “recovery” is that these debt burdens remain in place. While we certainly don’t advocate “freebie” principal writedowns – which would almost surely result in a tsunami of strategic defaults, we’ve long proposed what we’ve called Property Appreciation Rights as a way to partially substitute mortgage principal for a marketable claim on future appreciation. Failing any meaningful debt restructuring, however, we’ve got a financial system that continues to operate with a confident government backstop for risk taking, while aggregate demand remains suppressed by a burden of existing debt.

Tragically, nobody seems to have learned a thing from the dot-com crash, or the tech crash, or the housing crash. Wall Street continues to beg for monetary interventions to reward speculative trading, even though these rewards have repeatedly proved to be short-lived. What investors don’t seem to appreciate is how much of our nation’s scarce savings have been burned to ashes as a result.

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JH offers: “….nobody seems to have learned a thing from the dot-com crash, or the tech crash, or the housing crash. Wall Street continues to beg for monetary interventions to reward speculative trading, even though these rewards have repeatedly proved to be short-lived. ”

Just who is that “nobody”, John? Specificity, please. Does that mouse in your pocket want you to name names?

See it is just such willful refusal to call out the perpetrators in this madness that allows it to continue. It is really quite simple. Either the Banks are constrained and restrained, the financial system reformed providing balance as much as possible or we will ply the waters becalmed (at best).

A bit off-topic but here’s the digest of the 2010 Federal Reserve Survey of Consumer Finances. The numbers will not be news to anybody who follows this blog, but they confirm that the times are a bit dire.

Why do we even need banks? That is to say, for-profit institutions that lend money. Why not simply turn all banks into credit unions making zero profit? And why not simply shut down all the casino-capitalism gambling houses misnamed “investment banks” like Goldman Sachs?

Critics will scream that for-profit banks are needed to fund the risky but high-return enterprises which make this country great. But when we look over the past 70 years, most of the risky but high-return innovations like the internet (which started as DARPANET) and integrated circuits (which began as military cost-plus contracts for Minuteman missiles and the space program) and computers (which got their start calculating yields and geometries in the Manhattan Project and subsequent nuclear weapons design) and genetic engineering (which got its start from National Institute of Health research programs) were funded by the U.S. government, not by private capital.

At the risk of being irreverent and making light of a serious issue…the pirate flag reminded me of an old Monty Python sketch from the movie “The Meaning Of Life” about an accountancy firm that takes up piracy…

“It’s fun to charter an accountant
And sail the wide accountancy
To find, explore the funds offshore
And skirt the shoals of bankruptcy

It can be manly in insurance
We’ll up your premiums semi-annually
It’s all tax-deductible
We’re fairly incorruptible
We’re sailing on the wide accountancy!

FM responds: “Why not turn all businesses into not-for-profit institutions? Because they don’t work very well without the profit motive. Capitalism and all that.”

FM is usually spot-on, but this response doesn’t even make sense…as well as being factually false.

First, who said anything about “turning all businesses into not-for-profit institutions?” Only banks. How in the world do you leap from “turn banks into non-profit institutions” to “turn all businesses into non-profit institutions”? Major logic failure there.

Second, it’s clearly and obviously false that all businesses don’t work very well without the profit motive. As we know quite well, many types of businesses work better as non-profit institutions. For example, health care. The evidence here is conclusive: America’s for-profit free-market health care system grossly and shockingly underperforms nationalized single-payer non-free-market health care systems where profit is no longer the central motive.

We also have convincing data on charter schools, which cost much more and peform much worse than conventional taxpayer-supported K-12 schools. We also have hard data on for-profit prisons which (surprise!) perform much worse than the usual not-for-profit state-run institutions. And non-profit organizations like Wikipedia consistently whip the asses of for-profit institutions like Encyclopedia Britannica.

FM appears not to have noticed that America has a mixed economy. Some of our big institutions are not-for-profit, like the National Institute of Health. Other big institutions, like Apple Computer, are for-profit operations. Experience has shown that some types of institutions work better without the profit motive, while others work best with the profit motive.

The alleged “benefits” of the so-called “financial innovations” introduced by the big banks and brokerage houses and investment houses, like CDOs, in retrospect are limited to enriching the top 1% while ripping off the bottom 99%. In some business, like software or telecommunications, innovations often provide real benefits to the public. Financial “innovations” over the last 30 years have provided zero real benefit to the public. They are merely a fancy form of three-card monte, and should not be supported in the financial sector with for-profit multimillion dollar bonuses.

All valid points, and my statement was incorrect! As More notes, there are many examples of non-profits that work well — sometimes as well as for-profits. And we have non-profit banks that have worked well — some credit unions and mutual-owned savings banks.

It’s an interesting question how far the US could expand the non-profit sector. My personal experience with charities and service clubs suggests that they’re often inefficient — often of a crazy sort that would kill a business. But that’s not research, which would be interesting to see.

He gives a different sort of comparison, between for-profit and government-owned entities: for profit schools and prisons vs. the conventional government-owned institutions. 20th century history suggests caution in expanding that government-owned sector beyond the traditional institutions (eg, schools and prisons). There is a long history of massive failures: mines, manufacturing, services — and financial institutions (such as the government-sponsored enterprises, whose losses will be mind-blowing when the tab finally comes due).

The co-operative society Jord Arbejde Kapital was founded in Denmark during the Great Depression in 1931. The society issued a popular local currency which was subsequently outlawed by the Danish government in 1933. In 1934 it founded an interest-free savings and loan system and a Local Exchange Trading System. Though both systems were forced to close, the savings and loan system re-emerged in 1944. The experience of JAK-banking in Denmark inspired a group in Sweden to develop a non-profit organisation named Jord Arbete Kapital – Riksförening för Ekonomisk Frigörelse (National Association for Economic Emancipation) in 1965. This pioneers’ group developed a mathematical system based on Saving Points, designated the “balanced saving system”. The association grew slowly at first. In 1997, a legislative amendment required the association to receive a banking license from the Swedish Financial Supervisory Authority in order to continue operating as a financial institution, which was granted in that year. The bank’s deposits are insured by the government.

Presumably the corrupt political classes in the USA would never allow a JAK-style bank to operate in the USA for fear that it would spark a populist consumer revolt. If so, that indicates that significant structural obstacles exist to social and political reforms, in contrast to FM’s perspective, that “personal responsibility” is the primary problem.

War and Foreign Policy by Murray N. Rothbard — a chapter from Murray Rothbard’s For A New Liberty (1972?). excerpt:

One of the most perceptive and prophetic critics of America’s entry into World War II was the classical liberal writer John T. Flynn. In his As We Go Marching, written in the midst of the war he had tried so hard to forestall, Flynn charged that the New Deal, culminating in its wartime embodiment, had finally established the corporate State that important elements of big business had been seeking since the turn of the twentieth century. “The general idea,” Flynn wrote, was “to reorder the society by making it a planned and coerced economy instead of a free one, in which business would be brought together into great guilds or an immense corporative structure, combining the elements of self rule and government supervision with a national economic policing system to enforce these decrees…. This, after all, is not so very far from what business had been talking about….”11

The difference is that JAK neither charges, or pays, interest. My guess is that this threatens the Federal Reserve “fractional” scheme. Please correct if wrong, or elucidate on the issue of “Usury”, as it relates to the current predatory bank system, as appropriate.

Is the following an accurate framework for understanding predatory bank corporations? If not, why not?
(The last paragraph supports FM’s oft-stated viewpoint that social-political in the USA reform is dependent more on “personal responsibility” than removing “structural oppression”.)

. . . The current situation resembles the managed capitalism of Mussolini’s Italy, in particular. It shares a common intellectual heritage (in disappointed progressives who wanted to order society on a scientiﬁc understanding of human nature), the same political alliance (the collaboration of the state and the corporate sector), and some of the same techniques for securing consent (through public relations and propaganda). Above all, it shares with fascism the same deep suspicion of free humans.
. . .
And, as with any absolutist narrative, calling attention to the inherent injustice and destructiveness of the system is understood as an attempt to undermine our collective welfare. The whistleblower is worse than just a spoilsport; he is an enemy of the people.
. . .
Indeed, the real lesson of the twentieth century is that the battle for total social control would be waged and won not through war and overt repression, but through culture and commerce. Instead of depending on a paternal dictator or nationalist ideology, today’s system of control depends on a society fastidiously cultivated to see the corporation and its logic as central to its welfare, value, and very identity.
. . .
this mess is not the fault of a particular administration or political party, but of a culture, economy, and belief system that places market priorities above life itself. It’s not the fault of a government or a corporation, the news media or the entertainment industry, but the merging of all these entities into a single, highly centralized authority with the ability to write laws, issue money, and promote its expansion into our world.
. . .
This is the landscape of corporatism: a world not merely dominated by corporations, but one inhabited by people who have internalized corporate values as our own. And even now that corporations appear to be waning in their power, they are dragging us down with them; we seem utterly incapable of lifting ourselves out of their depression.
. . .
Our object … should be to understand the process by which we were disconnected from the real world and why we remain disconnected from it. This is our best hope of regaining some relationship with terra ﬁrma again. Like recovering cult victims, we have less to gain from blaming our seducers than from understanding our own participation in building and maintaining a corporatist society. Only then can we begin dismantling and replacing it with something more livable and sustainable.

Greece’s economy blew apart because a bunch of olive-spitting, ouzo-guzzling, lazy-ass Greeks refuse to put in a full day’s work, retire while they’re still teenagers, pocket pensions fit for a pasha; and they’ve gone on a social-services spending spree using borrowed money. Now that the bill has come due and the Greeks have to pay with higher taxes and cuts in their big fat welfare state, they run riot, screaming in the streets, busting windows and burning banks.

I don’t buy it. I don’t buy it because of the document in my hand marked, “RESTRICTED DISTRIBUTION.”

I’ll cut to the indictment: Greece is a crime scene. The people are victims of a fraud, a scam, a hustle and a flim-flam. And––cover the children’s ears when I say this––a bank named Goldman Sachs is holding the smoking gun. …

(1) As has been pointed out hundreds of times on the FM website, by expert economists like Krugman, by organizations like the IMF — the morality play explanation of the euro-crisis (it’s not just Greece) is bogus.

(2) Websites that start off with descriptions of secret documents are seldom worth reading.

I’m no economist, so I’m confused. Greg Palast is a Leftist (who admittedly has to “sell” his ideas to his audience in a form that is appealing) that is critical of the way that Big Banks victimized the Greek public. You seem to be saying that Big Banks have victimized the Greek public (by shifting risk to the public and not “de-leveraging” bad assets).

In simple terms, setting aside style, why is Palast’s analysis different from yours?

The capital flows that resulted from the EMU’s “one size fits” all monetary policy affected each nation differently. Germany benefited the most, as the policy was cut to fit them. Greece, the worst-governned and economically fragile, was warped the most. Banks were transmission channels for these effects. It’s an oversimplification, but works to think of them as mindless money channels. For example, Spain got too many houses. Eastern Europe got too many euro-demoninated loans, putting too much currency risk on them.

Once the system started to break, banks became passive. Banks can only deleverage by foreclosing on existing loans and refusing to make new ones, both of which drives the economy into debt deflation and depression. Hence smart governments slow the default process (proping up the banks as needed) and provide low-cost funding to encourage lending. If the economy crashes, a large fraction of banks inevitably go bust.

Investment banks a play different role, acting as financial engineers — usually pernicious. For example, Goldman helpped Greece (and US companies) hide debt (see Der Spiegel’s explanation). Their speculation is often destabilizing. Both are usually minor effects (everybody involved knew Greece was faking their numbers).